Approach D: Level expense recognition explained

As mentioned in prior posts, one of the options that the FASB & IASB are looking at for expense recognition under the new lease accounting standard is to have a single lease expense item in the income statement, which would be level over the life of the lease no matter what the cash flows. The following is my understanding of how the calculations would work.

We'll take three leases, each of which is five years long (1/1/2012 - 12/31/2016). Rent is paid monthly in advance (i.e., first payment is due the first day of the lease), and rent payments total $6,000 over the five years. All of them have an initial asset & obligation value of $5,000 (this requires different interest rates to deal with the different payment scenarios, which implies that the interest rate is the rate implicit in the lease.) Lease NoChange has rent of $100/month for the entire term. Lease Increase starts at $80/month for the first year, then increases by $10/month each year (i.e., $90/month in year 2, up to $120/month in year 5). Lease Holiday has no rent for the first year, then $125/month for the remaining 4 years.

The chart below shows the varied results for the asset and obligation with each scenario. Where the rent isn't equal over the life of the lease, there is also a deferred rent liability or asset (as with current operating leases that are leveled) and if the lease is early terminated, there will be a gain or loss.

"Straight line" is simply for reference purposes, to show what the profile would be with equal amortization each period. All of the examples would have slower amortization in the early months (the only way amortization would be faster than straight line in the early months would be if rent were higher at the beginning than at the end of the lease, which is rare; reduced rents for just a small portion of time at the end of the lease wouldn't change the overall picture).

How will the journal entries work? The following is my best guess, using the NoChange example above, for its first month (interest rate used is 7.69%):

 

Gross asset			5,000.00
	Current obligation			879.26
	Long term obligation			4,120.74
Setup of capital lease
Current obligation			100.00
	Cash capital rent payment			100.00
Capital lease rent payment
Long term obligation			73.59
	Current obligation			73.59
Reclassification of obligation from long term to current
Interest expense			31.40
	Accrued interest			31.40
Interest accrual
Depreciation expense			68.60
	Accumulated depreciation			68.60
Depreciation accrual
Lease expense			100.00
	Interest expense (reversal)			31.40
	Depreciation expense (reversal)			68.60
Reclassification to lease expense

While you might merge the last three transactions together, that's going to make it harder to see where the activity in interest and depreciation is coming from. Interest expense is calculated on the outstanding obligation after that month's payment (4900 x 7.69% / 12 = 31.40). Depreciation expense is plugged: 100 (average monthly rent) - 31.40 (interest expense) = 68.60.

Balances in the balance sheet accounts at the end of the first month:

Gross asset	5,000.00
Accumulated depreciation		68.60
Current obligation		852.85
Long term obligation		4,047.15
Accrued interest		31.40

You may notice that no interest is paid in the first rent payment. This is because with a lease that is paid in advance, as almost all leases are, the first payment is due the first day of a lease, before interest has had time to accrue. Interest expense accrues during the month and is paid the beginning of the following month. Unfortunately, while the journal entries example in FAS 13 shows this, all of the examples provided in the original exposure draft, and in all the discussion papers that I've seen generated by the staff, have used leases paid in arrears. That makes the calculations a bit simpler, but virtually no leases are written that way. I hope the staff will include a payments-in-advance example in the Revised Exposure Draft (and final standard), since this concept is often hard to get lessees and lessors to understand and accept. For leases paid in advance, the change in net asset for a period under Approach D equals the combined change in current obligation, long term obligation, and accrued interest.

The transactions wouldn't vary greatly for Increase and Holiday, but in those cases the Lease Expense won't match the current month's Cash Capital Rent Payment, and the depreciation expense will be smaller or even negative (for Holiday). The balancing entry would be booked to deferred rent liability.

I hope we'll see a more official presentation of how to account for leases using Approach D next month.

Today's board meeting: Setting the stage

This morning the FASB and IASB held a joint meeting at the FASB offices in Norwalk (part of a series of joint meetings all week long). The first item on today's agenda was a review of the outreach done on expense recognition options for the new lease accounting standard. As reported in my prior blog entry, the staff (and board members) held a number of outreach events with financial statement preparers, users, and auditors, and summarized the results in a paper available online.

Board members discussed their reactions to the responses received. They heard a strong plea for simplicity from the various constituents. Essentially all board members agreed that Approaches B & C were not practicable, even though several of them expressed that they felt one or the other was conceptually the best choice. That leaves Approach A (capital/finance lease accounting), Approach D (straight-line expense recognition), or a combination of the two, with the need to define some dividing line between them. (And, as one board member noted, there is a third model that they've already agreed to: operating lease accounting, off balance sheet, for leases of 12 months or less.)

In the discussion, calculation of the balance sheet with Approach D was clarified:  I'm going to make another post that looks at the calculations under Approach D a bit more. In essence, it's a plugged number, though the staff person didn't like the use of that word. But some board members are concerned about the conceptual basis for the calculation, considering that it doesn't fit the normal definition of amortization and depreciation. They want lease accounting to be consistent with the overall Conceptual Framework of accounting that they've been working on for years.

They noted that in outreach, real estate lessees almost unanimously preferred Approach D. Equipment lessees generally preferred Approach A. However, there are many permutations on leasing, and board members noted that it won't be possible to make the accounting fit every different motivation that management has for entering into a lease.

Some board members would prefer symmetry between lessee and lessor accounting, in part because it seems easier to defend conceptually. Others noted that lessor accounting is generally not considered broken, and that leasing of investment property is already being scoped out of the project, so they were less concerned about symmetry.

While IASB Chairman Hans Hoogervorst noted that some European standard-setters don't agree with putting leases on the balance sheet, he noted that support for that move was almost universal among the preparers and especially users of financial statements. It seems clear that that decision will not be revisited.

The boards plan to vote in June on the expense recognition profile. The staffs were directed to present as options Approach A, Approach D, and a combination, with several alternatives for how to draw the line between A & D (similar to current IAS 17; real estate vs. equipment; and others). The staff stated that they expect to have a few wrap-up questions to deal with at the July meeting, and they would then prepare the Revised Exposure Draft.

WSJ Article: Leases Suffer Identity Crisis

Yesterday's Wall Street Journal (May 22) had a sizable article produced by CFO Journal, titled "Leases Suffer Identity Crisis," reviewing the controversy over expense recognition in the new lease accounting standard. Most of what's discussed there we've already seen, though a few items are worthy of note:

• They expect the revised exposure draft to be released in "mid-2013"
• IASB Chairman Hans Hoogervorst is quoted as saying that leases “are somewhere in between a purchase and a service, so our traditional answers in accounting don’t give a simple way to do this. ... The only clear signal we have from investors is to get them on the balance sheet and to keep it as simple as possible.”

The article quotes both a preparer and an accountant as considering many of the proposals overly complex ("over-engineered") and not useful.

The Journal often doesn't make CFO Journal articles available on the web (see, for instance, the article noted in this post), but at least for now, it's available without a subscription.

Tomorrow's meeting will discuss expense recognition. I intend to listen live, and will report once it's complete.

Outreach results on expense recognition

At their February meeting, as previously reported, the FASB & IASB were split regarding the proper approach to expense recognition for leases under the new standard. They directed the staffs to do outreach, meeting with a total of nearly 200 preparers (companies and organizations that prepare financial statements), users (banks and analysts that use financial statements for investing and lending decisions), lessors, and auditors.

That work is now complete, and the boards will review the results at a meeting next Thursday, May 24. The summary is available online. Highlights:

Approaches:
The staff presented four options for reporting expenses:
Approach A: Identical to current capital/finance lease accounting: Interest expense calculated on the remaining liability balance, with depreciation expense recognized usually straight line.
Approach B:  Interest expense as in Approach A. Officially the remaining asset would be the present value of the remaining benefits, with depreciation the difference between the remaining asset at the beginning and end of the period. If remaining benefits are considered to be equal throughout the life of the lease, and rent payments are also equal, depreciation plus interest in any given period would be equal to the rent (and equal over the life of the lease). This was described as "interest-based amortization" at the February meeting.
Approach C:  Interest expense as in Approach A. Depreciation is based on considering the estimated consumption of the underlying asset over the lease term. For a real estate lease whose property is expected to be worth as much or more at the end of the lease, depreciation would equal principal repayment, and the total expense would give a result similar to operating lease accounting. For an equipment lease whose property is completely used up during the lease, the result would be the same as Approach A. A lease in between would get a proportionate result. This was described as the "underlying asset approach" at the February meeting.
Approach D: This was not discussed at the February meeting. A single lease expense item would be reported, equal to the straight-line rent. It is not clear how the asset and liability would be calculated for balance sheet purposes (I believe liability would be the same as for other approaches, but I've seen no indication of how the journal entries would work for it or for the asset amortization).

Users:
Nearly all users reported that they attempt to capitalize lessees' operating leases currently to get a better picture of a company's financial situation. However, they had a variety of methods of doing so, on both the balance sheet and the income statement sides. There's no way to provide matching results for everyone.

Most users thought a single model for all leases would be best, though they recognize that people lease for different reasons. Most preferred either Approach A or Approach D.

Preparers:
Most thought Approaches A & D would be least costly and difficult to apply. Some thought that C would be prohibitively costly; some retail lessees reported having over 15,000 leases that are regularly renegotiated, which they considered would make reassessing the consumption pattern impracticable. Preferences were often influenced by the type of leasing a preparer did: retail lessees tended to prefer D while oil & gas lessees preferred A. Some argued, though, that D would call into question recognizing the leases on the balance sheet.

Lessors:
There was no agreement on whether symmetry between lessee and lessor accounting was critical, though it was noted that a lack of symmetry could make sublease accounting "anomalous." Lessors said they would not always be able to provide information to lessees regarding valuations (residual values, etc.), because that is sometimes confidential for competitive reasons. While they find the receivable and residual model proposed for lessors to be appropriate for assets that are leased just once or twice, they find it less appropriate for longer-lived assets that are leased multiple times to different lessees, and would prefer current operating lease accounting for such transactions.

Auditors:
Some have questioned whether Approach C in particular is auditable. Auditors believe it is, but that it would be the most costly approach to audit (and for preparers to implement). They also question how to test and account for impairments under B and D because of the unusual method of calculating the net asset.

We'll see if the boards can reach a consensus at next week's meeting. It's not outside the realm of possibility that they'll punt the issue, offering more than one alternative in the revised exposure draft and asking for responses, making the final decision during redeliberation.

FASB meets with Small Business Advisory Committee

This morning the FASB met with the Small Business Advisory Committee. The meeting is continuing as I write this, but discussion on leases was near the beginning of the agenda, and that's what I'm concerned with.

A FASB staff member gave a bit of an update of the outreach they've been doing since the February meeting, when the FASB and IASB considered some options for expense recognition on leases in the new standard. They've been meeting both with companies that would apply the standard ("preparers") and analysts ("users"). They've found that among users, there is near unanimity in agreement on the balance sheet approach planned for the new standard (i.e., capitalizing essentially all leases). There is, however, considerable diversity on the income statement side, selecting from among the options that the board is considering.

The presentation at this meeting included three alternatives to the current capital/finance lease model, rather than the two discussed at the February meeting. In addition to February's interest-based amortization and underlying asset approaches (see my prior summary of these), they showed an "Approach D," which is straight-line rent expense, like current operating lease accounting. It wasn't clear how the balance sheet balances would be amortized in such a situation: Would the asset and liability be shown undiscounted, and then amortized straight-line, or would they be shown as the present value of remaining rents (either based on cash rents or the straight-line equivalent), or something else?

In general, the committee expressed strong support for level expense recognition, considering that capital lease accounting provides unhelpful information in their environment. Some still want to make the case for it being off the balance sheet ("If I can't sublet, do I really have an asset, since I can't transfer it?") I don't see any likelihood of that prevailing.

Some expressed support for handling real estate differently from equipment, making the argument that real estate leasing is more about reducing risk (knowing what your rent will be into the future) while equipment has more of a financing approach (I can't afford to buy it up front; though often an equipment lease is related to wanting the equipment for a limited time, wanting quicker upgrades, etc.). This was in support of level expense recognition for real estate even if equipment used the standard financing model.

A FASB board member, however, said he didn't like the idea of basing the accounting on the type of underlying asset. He wondered if they could define characteristics that justified the different treatment. One that he mentioned is that in a real estate lease, the asset is expected to have little or no reduction in value (a land lease particularly exemplifying this concept).

Another committee member suggested that if the present value of the rents is less than "about" half the value of the underlying asset, operating lease accounting should be acceptable. But he didn't have a good answer for how to draw the line between leases that would and wouldn't qualify. A major issue driving the revision of lease accounting is that similar leases (those just barely on opposite sides of the capital vs. operating dividing line) are accounted for very differently.

A banker commented that many leases are written to game the accounting rules, and she fully expects the same thing to happen under the new rules. A particular area of potential vulnerability that several people saw is the issue of substitutability--according to the current draft, a lease requires a specific asset to be named, and if the asset can be freely substituted (so that it's the output of the asset, rather than the asset itself, that the lessee is controlling), it's a service contract rather than a lease. It was suggested that lessors may start writing leases so that all kinds of equipment are officially subject to substitution. Whether "substance over form" principles will protect against that is unclear.